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The New Revenue Recognition Standard: Guide for Asset Managers

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The New Revenue Recognition Standard: Guide for Asset Managers November 2019 The New Revenue Recognition Standard: Guide for Asset Managers By Sabina Miroshnikov, Audit Supervisor In an effort to address concerns surrounding the inconsistencies and weaknesses in existing accounting for revenue transactions, Accounting Standards Codification 606, Revenue from Contracts with Customers, (“ASC 606”), establishes a principles-based approach for revenue recognition (regardless of industry or geography). The new guidance will: • Provide for a more standardized foundation for addressing revenue issues; • Improve comparability of revenue recognition across entities; • Provide more useful information to financial statement users through improved disclosure requirements; • and simplify the preparation of financial statements by reducing the number of requirements to which an organization must refer. Although, the impact of adoption of the new standard may vary between entities, asset managers will need to re-evaluate fee arrangements under which services are provided to determine accounting changes that will need to be implemented. Those fee arrangements include: • Management fees, unitary management fees and related fee waivers and expense caps; • Incentive or performance fees, including carried interest; • Reimbursement of startup or ongoing costs; • Distribution and related fees, such as fees paid out of fund assets to cover marketing and selling fund shares (12b-1 fees) © 2019 Richey May & Co., LLP All Rights Reserved 1 NOVEMBER 2019 The New Revenue Recognition Standard: Guide for Asset Managers Transitioning to the New Standard The standard allows for either full retrospective or modified retrospective adoption methodology. Under the full retrospective approach, ASC 606 requires determining the cumulative effect of applying the new standard as of the beginning of the first historical period presented, and a comprehensive recasting of the prior year’s financial statements as if the new guidance had always existed for a comparative two- year period prior to the year of adoption. The full retrospective approach may be preferable to provide consistency and comparability between periods. Under the modified retrospective approach, entities should apply the amendments to the new standard to all new contracts initiated on or after the effective date. For contracts which have remaining obligations as of the effective date, a cumulative catch up adjustment to opening balance equity should be computed and recorded. This approach can be more cost-effective and less time intensive as it does not require a high volume of data to recast the accounting for prior periods. However, it requires an entity to maintain two sets of accounting records in the year of adoption to meet expanded footnote disclosure requirements. The Core Principle of ASC 606 The core principal of the new standard is to “recognize revenue to depict the transfer of goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services.” In order to achieve the core principle, entities should apply the following five steps: Identify the Identify the performance Determine the contract(s) with a obligations in the transaction price. customer. contract. Allocate the transaction Recognize revenue price to the when (or as) the entity performance satisfies a performance obligations in the obligation. contract. © 2019 Richey May & Co., LLP All Rights Reserved 2 NOVEMBER 2019 The New Revenue Recognition Standard: Guide for Asset Managers Application of the Five-Step Model as it relates to Asset Management Step 1: Identify the Contract with a Customer ASC 606 defines a contract as “an agreement between two or more parties that creates enforceable rights and obligations.” The contracts can be written, oral, or electronically produced. Under ASC 606, asset managers should combine contracts if: • Two or more contracts entered into at or near the same time with the same customer are negotiated as a package with a single commercial objective; • The amount of consideration paid in one contract depends on the price or performance of another contract; • The goods or services promised in the contracts are a single performance obligation Who is the customer? An asset manager typically enters into contracts with funds (investment pooling vehicles), which allow investors to benefit from an asset manager’s services, raising the question as to which party would be considered the customer, the fund itself or the investor. This determination could affect the following: • The timing of revenue recognition: For example, if an asset manager has multiple contracts or promises in a contract, that would either be accounted for separately or together, depending on who the customer is for each individual contract or promise. • The accounting for certain costs: For example, costs associated with launching a new fund or obtaining new investors could be either expensed as incurred or capitalized depending on whether they are associated with obtaining customers or fulfilling performance obligations. Financial Accounting Standards Board (“FASB”) and International Accounting Standards Board (“IASB”) board members concluded that given the wide variety of structures, there is no single determinative factor when identifying the customer in relation to the revenue recognition guidance, leaving it up to each entity to be thoughtful about the specific facts and circumstances of each arrangement and apply a consistent approach in performing the evaluation. © 2019 Richey May & Co., LLP All Rights Reserved 3 NOVEMBER 2019 The New Revenue Recognition Standard: Guide for Asset Managers The following indicators have been developed by the Financial Reporting Executive Committee (“FinREC”) for use by the asset management industry and may be used as a framework to assist preparers in applying judgment to their specific facts and circumstances. The existence or absence of any one indicator should not be considered final. Indicators that the fund is the customer include: • The fund is a separate legal entity that may be set up as a partnership, corporation, or business trust • The fund is governed by a board of directors or other form of governance, which is independent of management of the fund • Fee arrangements for management and advisory fees are negotiated by the fund and applied consistently by the investor class • A large number of potentially diverse investors is an indicator that the asset manager’s relationship is more directly with the fund • The fund lacks visibility as to who the ultimate investor is because investors have subscribed through a third-party broker-dealer’s omnibus account • The fund is highly regulated, as is the case with registered investment companies in the U.S. These characteristics are common in a mutual fund. Indicators that the fund investor(s) is the customer include: • The asset manager enters into individual “side letter” arrangements regarding management fees with individual investors (as may be common in certain partnership structures) • There is active negotiation of fees or interaction between the asset manager and individual investors or a small group of investors that control the fund’s activity directly or indirectly through their role on the board or governing body (that is, the investors as a group act together as the fund’s governance structure) • The fund is not governed by a board of directors or other form of governance, which is independent of management of the fund • There is a single or a limited number of investors, where the investor(s) has influence over the service arrangements. These characteristics are common in a private fund, such as a hedge fund. © 2019 Richey May & Co., LLP All Rights Reserved 4 NOVEMBER 2019 The New Revenue Recognition Standard: Guide for Asset Managers Step 2: Identify the Performance Obligations in the Contract Asset managers generally provide a number of services (performance obligations) to customers, these services may include, but are not limited to, investment advice, research services, overseeing the preparation of books and records, financial statement preparation, underwriting, distribution of fund shares and preparation, printing and distribution of prospectuses, reports and sales literature. Determining which party is the customer is an important consideration in the unique asset management industry. All arrangements will need to be analyzed to determine the goods and/or services the entity promises to transfer to a customer at contract inception. A good or service that is promised to a customer is distinct if the customer can benefit from a good or service either on its own or together with other resources that are readily available to the customer. In certain cases, the asset manager may not need to enter into separate legal agreements with a customer as the fund’s governing documents may explicitly state the services to be provided by the asset manager. Step 3: Determine the Transaction Price “The total transaction price is the amount of consideration the asset manager expects to receive for performing asset management services and includes both fixed and variable amounts.” The idea of variable consideration applies to contracts where the revenue will be recognized over time rather than at a point in time. Under ASC 606, variable consideration amounts must be estimated and included in the transaction price “only to the extent that it is probable that a significant reversal in the amount of cumulative revenue
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